Quarterly Commentary: The End is Nigh?

10 April 2017

During the first quarter of the 2017 calendar year the leading global markets continued in much the same vein as the final quarter (and calendar year) when 2016 drew to a close. The UK’s benchmark FTSE 100 Index rose 2.5% to 7,322.92 during the first three months of the year, supported in no small part by the continuing relative weakness of Sterling as well as perennially low base interest rates. Towards the end of the quarter, defensive equities came to the fore once again, with 'heavyweight' stocks such as British American Tobacco, Unilever and Reckitt Benckiser all approaching 3-month (and all time) relative highs. The shares of global consumer companies in general were greatly coveted and supported with significant demand after Kraft Heinz made its audacious takeover bid for Unilever on 17th February. Whilst the bid was swiftly rejected then withdrawn, it nevertheless highlights the fertile ground that the UK market currently represents in terms of potential M&A activity.

On the 29th March the UK finally invoked Article 50 of the Lisbon Treaty and by doing so, formally started the two year process of negotiating with a view to eventually leaving the EU (i.e. a complete “Brexit”!). When Tim Barrow (the UK’s ambassador to the EU) delivered Prime Minister May’s formal notice to EU President Donald Tusk, it marked the first time that a country had opted to leave the EU bloc. The UK and EU must now embark upon two years of negotiations regarding a plethora of issues, with a comprehensive free trade agreement being of the utmost importance. Early indications from both sides are mildly positive and the hope is that some meaningful progress can be made towards a new mutually amicable and successful economic and political relationship between the UK and Europe over the course of the next two years.

At the time of writing our £ Sterling is trading around a 31-year low versus the US Dollar, in spite of a marginally positive first quarter (gaining 1.2% versus the “Greenback”). It is fair to say that the weakness of the British currency is in large part a reflection of the market’s expectations for protracted 'Brexit' negotiations between the UK and the EU. Having said that, currency weakness is, of course, a double-edged sword and there are some positives to be noted: inbound tourism to London is approximately 20% higher than at this point last year (when the £ Sterling was approximately 13% higher versus the US Dollar) and business investment in new domestic capacity has been evidenced in some quarters. Furthermore, UK assets are beginning to appear more attractive to overseas investors, with the £1.15bn purchase of London’s Cheesegrater skyscraper as well as the aforementioned Kraft Heinz bid to buy Unilever just two prominent examples of relatively cheap (to overseas buyers) UK assets.

Rising food and fuel prices, partly due to the aforementioned £ Sterling weakness, pushed the headline rate of inflation (CPI or Consumer Prices Index) to 2.3% in the year to February, from 1.8% in the year to January. This was the highest reading for more than three years, and above the Bank of England’s 2.0% target. Furthermore, core inflation, which excludes certain volatile items such as food and fuel, rose 2% in the year to February, from 1.6% in the year to January. After a benign period of several years, the relatively sharp increase in inflation coupled with a slowdown in wage growth has added to concerns over many families’ standard of living.

In terms of UK interest rates, the Bank of England’s Monetary Policy Committee (MPC) has stated that it is happy to let inflation rise some way above its target, as it balances the need to support growth and jobs with keeping price rises in check. However, one member of the rate-setting Committee voted for a rate rise in March. Other members indicated that they may also consider voting for a rise in the near future. Whilst we do not believe that rates are necessarily going to rise on a steep trajectory, should accelerating and rising inflationary pressures persist then we envisage at least a 0.25% increase in the base rate at some point in the not too distant future – my thoughts at the beginning of the year were around April or May and I still favour this stance. However several Economic commentators did forecast nil rate rises throughout the entire 2017 calendar year. To augment this view, price action in the Government Bond markets suggests that rates are going nowhere fast. The benchmark 10-year Gilt yield fell from 1.239% to 1.139% over the quarter, perhaps signalling the market’s concern over a number of factors including the ongoing debate around Brexit, the upcoming French Presidential Election, general geopolitical/terrorist issues and also the somewhat turbulent start to Donald Trump’s administration in the US.

Following on from the above and staying across the pond in the US, President Trump failed in his high profile bid to repeal the Affordable Care Act (ACA or 'Obamacare'). Defeat over his flagship manifesto pledge has raised the question of whether many of his other manifesto pledges will suffer a similar fate. Nevertheless, the President appears unperturbed and is expected to re-energise his efforts to push through his corporate tax reform agenda.

Despite the boon of OPEC’s production cut in late 2016, oil suffered a weak start to the year with Brent Crude slipping by approximately 5.5%. This follows its astonishing rise of some 53% over the course of calendar year 2016. However, many commentators point to evidence of falling crude oil inventories around the world (excluding the US) as a sign that the price of 'black gold' will be supported as we enter the seasonal peak demand period. Indeed, at the time of writing the Brent price has already rebounded over 2% since the quarter end. Further geopolitical tensions, recently highlighted by the Syrian situation, may well see the price of crude rise even further.

Regular readers of my commentary will know that I am a keen follower of the Baltic Dry Index (BDI). As a reminder, the Index tracks worldwide international shipping prices of various dry bulk cargoes and as such is viewed by many commentators as a leading economic indicator and guide to predicting business activity. Global shipping represents an important benchmark for the global cycle and I am pleased to report that the BDI increased by some 35.0% over the first quarter of the calendar year. Freight rates have doubled from their low in 2016 and the management of Maersk (the global container shipping company) has suggested that container shipping volumes will grow 2%-4% this year. This potentially augurs well for the global economy and is perhaps another tentative sign of global growth gaining further traction – however this also adds credence to a commencement of the interest rate tightening (raising) cycle!

In conclusion and as my title suggests, the end may be nigh for enduring 'ultra-loose' monetary policy. Rising inflationary pressures and relatively strong business confidence indicators in the UK, Europe and US are seen by many as reasons to call time on the near zero interest rate policies that have been adopted across the developed Western economies since the financial crisis. Many also argue (I share a deal of this sentiment) that debt fuelled consumer spending and the rising values of non-cash assets including quoted stocks and residential property (in several areas) do need to be arrested/slow down – this would prevent a more serious so called 'boom/bust' scenario.

In fact, as is often the case, the US is already leading the way - in March 2017, the US Fed sanctioned a third rise in its target funds rate in the space of 12 months (by 0.25% to a range of 0.75% - 1.0%). Furthermore, the Fed chairwoman (Janet Yellen) predicted two further rate increases during the remainder of 2017 in what was seen by many as a speech that implied a vote of confidence in the US economy. Indeed, Yellen said that “growth is a touch stronger, unemployment is a shade lower”. Whilst GDP growth over recent years has been consumption (rather than investment) led and consumption cannot be relied upon to drive future GDP growth in a higher-inflation world. Nevertheless, relatively robust economic data from across the globe continues to provide encouragement that generally higher growth, higher inflation, higher bond yields and higher interest rates will ensue.

However the aforementioned scenario is by no means a certainty and I wonder whether one or two rate rises in the UK will be followed by a return to more anaemic economic conditions and a fall in interest rates – perhaps in 2018? More evidence of the conundra facing the team and I!

In terms of markets there are obvious risks facing global economies and as per my long held belief, stock selection and diversification is of paramount importance as the gap between the winners and the losers remains stark and potentially damaging to investment portfolios. However, should our £ Sterling remain weak (which I believe it is likely to in the short term at least – however it may well rally if or when rates are increased) then I would expect more overseas investment into the UK. Furthermore I would also not be surprised to see more predatory M&A activity (notwithstanding any political intervention to protect the interests of British businesses) with regards to prominent UK-listed companies such as the aforementioned Kraft Heinz bid for Unilever. Hopefully this will be the scenario, although I remain alert to overpriced stocks and a potential seismic shift in investor sentiment.

As ever your usual adviser will be happy to offer assistance with portfolio planning and asset allocation or other specific investment queries.

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